Page 240 - FM Integrated WorkBook STUDENT 2018-19

Chapter 13

The causes of exchange rate fluctuations

4.1 Purchasing power parity theory (PPPT)

PPPT claims that the rate of exchange between two currencies
depends on the relative inflation rates within the respective countries.

 ‘the law of one price’

 the country with the higher inflation rate will be subject to a
depreciation of its currency.

Formula to estimate expected future spot rates:

(1 + h c)

S 1 = S 0 × ––––––
(1 + h b)

h c represents the inflation of the country with the counter currency and
h b represents inflation in the base country

Limitations:

 the future inflation rates are estimates

 the market is dominated by speculative transactions

 government may intervene to manage exchange rates

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